To track the intended -- and more importantly, unintended -- consequences of policies,market movements,buyout deals and regulatory censure. This forum will map the multiplier effect of what may seem minor events initially but spread out far and wide.

10/06/2010

Countries pulling down their currencies to combat the yuan,triggering currency war

A currency war is brewing. And it is no longer between the two largest economies of the world, setting off what's beginning to look like a new age ‘beggar thy neighbour’ game.

The US House of Representatives last week passed the Currency Reform for Fair Trade bill to institute a mechanism that will investigate if a foreign currency is fundamentally undervalued – read yuan – for a 18-month period. If so, US can impose counter-veiling or anti-dumping duties that will correct the misalignment.

While the bill has to be cleared by the senate and signed by the president before it becomes a law, China has been quick on its defense.

US believes China’s historically undervalued and tightly controlled currency is hurting its economy through what it alleges to be ‘trade subsidies’. That could well be true.

China believes that the latest bill targets the yuan, violates the World Trade Organization rules and signals rising US protectionism. That could be true too.

But even as these two countries thrash it out in this currency slugfest, the undercurrents of this is forcing countries to re-align worldwide.

Japan’s central bank surprised the markets and worried the IMF by re-instating its ‘zero interest policy – it had gone off this in July, 2006 – and announcing plans to inject liquidity in the system to stimulate its domestic economy. It had not intervened in the foreign exchange markets in six years.

China’s undervalued currency makes exports such as those from Japan look cheaper, thereby edging out competition. To boot, China is now the biggest exporter and that amplifies the trade distortions.

Japan is not alone in deciding to bid 'yen' down. Switzerland had undertaken an intervention against the ‘Swiss franc’ in 2009 for the first time since 2002 but did not sterilise it by buying back the additional money supply in the domestic money markets. South Korea has been holding down its ‘won’ for some time. So has Taiwan.

Brazil has been complaining about how its ‘real’ has been appreciating against the dollar but it too has authorized its sovereign wealth fund to sell the currency on its behalf.

These measures are effective only if they are not matched by the trading partners of countries. For now, this trend seems to be going viral and that is not good news.

How far will China back down and allow its currency to rise in the face of heightening global pressure and a pending US bill? Hard to guess but that will be key to defusing this situation. Other countries will likely stop if they can rest easy that their cost competitiveness is not being preyed upon.